Monday, August 31, 2009

Long Post Late Tonight

Friday, August 28, 2009

Deflation It Is

Really sorry for the absence, but I am running so tight on time that I have been quite short of sleep for two weeks.

However, part of the problem has been family medical problems which have been sucking up a lot of my time. Those are all greatly improved and I will have more time next week. I am vastly relieved over the outcomes.

These last few weeks have been decision points for a time for the US economy, so I have been trying to keep up with the retail survey. And the results are now unequivocal. The BEA is wrong. Real incomes are dropping quite substantially; we are doomed to deflation. The problem is both incidental consumer credit and lower incomes, and thus is quite intractable.

The reason why this time of year is so decisive an index in retail is due to several factors which give a reasonable observer a fix on two important US demographic segments. The first segment is the seniors, comprising about 12% of the US population, but having a disproportionate share of the assets on the whole. At this time almost all seniors are moving out of the doughnut hole and into the second period of prescription coverage. This gives the segment as a whole a boost in incomes, and you can see the effect in stores (since Part D was passed). This year it is a total bust. Stores have been trying to raise food prices and failing miserably.

The second are families with school age children who do spend substantially for back to school. The bulk of the spending is stuff like stationary, notebooks, clothes and shoes. Spending there has been constrained, shifted to discounters, and spread out over a much longer period than normal.

The implication here is that US consumers are totally tapped out. There will be no infusive boost, and the more energy prices rise, the more US consumer profits will fall.

Thus, if the Fed fails to raise rates this year, the excess of money out there will remain in commodities, and the US will subside into a second period of economic decline. On my last post, I thought David Pearson explained it well:

What do you call a situation where incomes are deflating in nominal terms at the same time that one group of prices is rising steeply?

I call it a Latin American country after a maxi-deval. Import prices go up, domestic (i.e. services) prices deflate, unemployment spikes, and real wages take a big hit, which in turn spurs manufacturing exports.

It does seem to fit the current U.S. situation, doesn't it? What do Latin Central Banks have to do after such a deval? Raise interest rates to get the currency to stabilize, just as you suggest. This is called an "austerity measure", and it was U.S.-imposed dogma during the 90's. Ironic, isn't it?

For the record, my Spanish is quite good. I do not find this ironic at all - it is a matter of economic fundamentals.

What I do find ironic is that economists should cling to words associated with theory without clarifying their own thinking. There are multiple causes for a rise in prices, and one of those causes has nothing to do with money supply, but cost of production and the cost of holding real assets. Negative real interest rates create a situation in which the cost of holding commodities is very low. In terms of supply and demand relationships, many current commodity prices are asinine. But when you calculate in both the expectation of some rebound and currency/interest rates, abruptly these prices look more realistic. However, the prices are created not by economic fundamentals, but by central bank policy.

China is giving up its battle to create bubbles, in part because it has apparently realized that it is likely to hurt its internal economy. They will ease off slowly. But the Fed is pushing on the wrong string and is going to end up cutting the throat of the US economy, and when it does, there is a possibility that the Chinese retraction, combined with the Japanese situation, combined with world excess production capacity, combined with the worsening fundamentals in some South American economies, combined with hysterically bad US legislative policy will all add up to a genuine world depression. I hope not, but the possibility now exists.

Failure to properly examine what happened during the Great Depression has left many economists babbling nonsense. All types of stimulus are not equal, and stimulus projects that do not cycle income directly through the population along with attempts to throw money into the financial system simply divert economic corrective processes into the creation of new bubbles, which must inevitably deflate.

This all should be considered jointly with Japan's situation. Japan has consumer deflation without a doubt, very much lower exports (especially to China), and apparently shrinking consumer incomes. It is almost impossible for the world economy to revive if both Japan and US consumers are hacking lower like this.

In a few days I should be back posting much more regularly unless further disasters occur. Until then, I would like to leave you with this FACT:In the wake of the Great Depression, professor salaries were cut 30-50%. I am in possession of an article written in the 1930s by a Yale faculty wife, which laments the passing of the "genteel" class, and records that one-tenth of their income was being spent solely to buy milk for their children.

Think about it. At that time the "upper middle class" suddenly experienced plumber envy. The time of free fantasy is over. Then factor in similar (although milder) income trends and consider the massive amount of debt held by this segment of our population. It ain't pretty, folks.

The United States economy is now out of the emergency room and appears to be on a slow path to recovery. But enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects. For now, most of those effects are invisible and could indeed remain latent for a long time. Still, their threat may be as ominous as that posed by the financial crisis itself.

To understand this threat, we need to look at where we stand historically. If we leave aside the war-impacted years of 1942 to 1946, the largest annual deficit the United States has incurred since 1920 was 6 percent of gross domestic product. This fiscal year, though, the deficit will rise to about 13 percent of G.D.P., more than twice the non-wartime record. In dollars, that equates to a staggering $1.8 trillion. Fiscally, we are in uncharted territory.

Buffet goes on to point out that the biggest issue relating to the deficit and borrowing is our current account deficit, or the fact that we import far more than we export. If we exported more than we imported, the debt would not be nearly such a big issue. His numbers are pretty good, and of course this explains why no one who understands anything pays any attention to the Treasury's claim that the debt will not be monetized. Of course it will.

So what will happen?

Well, first we will have to pay higher interest rates on our debt, which will greatly magnify the effect of the deficit. People will lend you money (buy Treasuries) only as long as they are paid interest. And if you monetize the debt, the interest rate will get higher and higher. So the dollar will deflate, which will lead to inflation on all imported items, which will lead either to domestic inflation (if enough money is circulating to allow individuals to keep paying higher prices) or to deflation (debt payments absorb more and more money from the economy as a whole, thus less money is circulating, so individuals have less money, they spend less on discretionary items, which leads to lower profits, magnifies the percentage of income going to pay off debt, and lowers living standards).

Of course, economics dictates that a balance will be reached, and it will. We are currently in a deflationary cycle, in which buying power of the average citizen continues to decline. This means that current account deficit will continue to drop, because citizens will, on average, be buying less of imported items. And as we buy less, corporate profits will continue to be constrained, which will lower domestic corporate income and expenditures. That is the story of the cost-cutting seen at major retailers, which has included much lighter stocking. That is also why China is continuing to pump a bubble. Their exports are not recovering, and they haven't figured out how to raise consumption ex-bubble, thus they are now doing to their own economy what we have been doing to ours. Eventually, it will catch up with them.

I think Buffet's article is very clear, but I disagree with his theory that this process is latent. It is not latent. It is the dominant factor now controlling the economy in tandem with our banks loaded with bad debt. Both factors will decline to suppress consumption and reinforce the deflationary cycle, because we cannot afford to import all those goods:

What you see there is what is happening to our current account. Note that it was in balance up until the 1980s, then steadily worsened, with minor corrections on recessions, and has massively improved over the course of the current recession.

The only way to stop the ever-worsening cycle of domestic deflation is to raise interest rates, and the time to do so is running out. The Fed needs to raise rates about 40-50 basis points (about half a percentage point) this year. In effect, the situation with credit cards (also reflected in incidental credit) is going to continue to raise the cost of borrowing for the consumer. Thus only jobs and higher incomes or writing off huge chunks of consumer debt can reverse the decline in the consumer side of the economy. Those jobs will not appear unless the Fed starts to tighten because business profits will be impaired by higher input costs.

The timing on this is so very tight because the US desperately needs to raise taxes broadly, and it cannot do so without the seeds of an economic expansion or it will produce the next leg downward. But the US will not get a self-sustaining expansion unless energy costs are controlled, and it is now clear that energy costs will not be controlled as long as the dollar's fate is so uncertain.

Monday, August 10, 2009

Wanted To Make Sure

I came back from a round of store checks this morning. Before I committed myself, I wanted to make sure that my personal observations matched the data that I get.

David asked about NACM, and had earlier commented on incomes. NACM is similar to ISM. The latest reports for both NACM and ISM show manufacturing either on the verge of entering into a growth cycle or soon to get there, but have services falling back. For example, between June and July NACM showed a huge jump in manufacturing credit apps. (For manufacturing, the turn was in May for credit apps.) Conversely, in July there was a small drop in services credit apps and collections. Generally NACM services will follow manufacturing trends in one to two months, but manufacturing was still marginally negative in July. Based on credit apps and collections for manufacturing, one would expect an improvement in services activity by October at the latest. It all depends on whether manufacturing can sustain the current trend and whether declines in consumer spending do not overwhelm the manufacturing growth (when that occurs).

In ISM, the services divergence is more striking, especially when one looks at the detail. Last month's export orders contracted sharply, employment is declining faster, and inventory sentiment, although improved from the prior month, is still quite negative at 62.5 (too high). Further, prices turned and dropped.

Chicago PMI is a nice detailed survey, and in July was pretty consistent with the others. A smaller decline offering future hopes, but continued declines in employment, and lower prices (prices were increasing in manufacturing ISM). The three surveys offer a picture of an economy with slowing business activity in July, but the rate of decline was small enough to offer hope and support to those who are forecasting a return to growth over the next few months.

However, the naysayers are still free to observe that trends in consumer spending and small business appear to be worsening a bit (see the NFIB July report). These are large economic segments, and the sharply negative employment outlook for small businesses combined with their extraordinarily low capital expenditure projections can hardly be considered a positive. The latest figure for actual sales (June) in small businesses matched its prior low in March. Thus, I turn a cold and fishy eye upon the ISM's claim that their manufacturing survey indicates that the economy has been expanding for three months. The only real bright spot in the small business survey is that the one thing they ain't complaining about is credit. Only 6% of firms reported financing and interest rates as their major problem. Most, in fact, were concerned about poor sales.

Now this is where the whole thing gets interesting. Internationally, the major industrialized countries (save for China) show similar trends: improving manufacturing conditions, weak consumer spending, worsening unemployment, falling prices, a growth in business failure loan losses, and weak business investment. Thus, it is doubtful that the US economy will get much help from external buying.

The situation in retail is quite difficult. Many retail ops are still going out of business, light stocking is quite prevalent and seems to be getting worse, and food prices have fallen so hard in the last few months that there will have to be a rebound. Producers will sell under cost in order to get loan payments, but they don't restock and resupply when the prices they receive add up to less than their production cost.

Further, any hint of an economic rebound is tied to significant jumps in oil prices. Consumption is still falling, and stocks are very high, but that means nothing in this environment. This leads me to several conclusions, the primary conclusion being that the Fed really needs to raise interest rates a couple of times before the end of the year. That will knock the stuffing out of what is currently one heck of a bubble. If they don't, I think the chance of another retraction after a few months of growth (when we get there) is nearly 100%.

Next I would like to discuss what I have on retail and what I think it means.

Friday, August 07, 2009

Back Posting Sunday/Monday

Don't bother to get excited about the employment report. It's not all that.

The next wave is coming - take a look at this graph of the percentage of unemployed workers who have been unemployed for 27 weeks or more.

Credit losses.....

According to the household survey of the employment report, we lost 155,000 total jobs in July and unemployment rose 267,000. So how'd the unemployment rate drop? Well, the "Not in labor force" cohort grew by 637,000. There are 8.8 million people working part-time jobs because that's all they can find. There are 14.5 million unemployed.

The establishment survey shows the heartening uptick expected from the shipping data in June - private hours worked in manufacturing rose .3, which is a heck of a nice change. The downside, as the ISM and NACM surveys show, is that services are still weakening. Unless the government gets around to passing more stimulus bills with actual stimulus in them, weakening private incomes and declining sales of consumer goods - not to mention the effect of collapsing small businesses - will overcome this uptick in manufacturing.

The seasonal adjustments for June/July were somewhat distorted by the odd patterns in the auto industry. I had expected to see very similar numbers to this report in June. Just swap the two reports, and you get an idea of what's coming down the pike.

One of the most interesting things out there is to watch the trends for older employment (See Table A-6) and compare them to younger employment. The number of employed persons 55 or older has increased over the last year:

July 2008: 26,886,000July 2009: 27,158,000

But the number of men in that age bracket who are working has declined. The increase comes from women who are 55 and older:

July 2008: 12,580July 2009: 12,929

I bet a lot of men have taken early retirement, and their wives have taken part-time jobs to try to cover the income loss. Table A-7 gives you unemployment rates by age.

Between 79 and 83 3 percent of the population lost their jobs. We've now managed to top that handily - by about 1%. The critters have been complaining about the teabaggers - one can only wonder how they will react to the rocksalters.

Tuesday, August 04, 2009

The Plot Thickens

The next item - which I will henceforth refer to as Humpty Dumpty - is a new incentive program for servicers and investors. In this one (the HPDP segment of HAMP), the Treasury will pay an incentive each month for 24 months for successful modifications. The amount of the incentive is pegged to expected housing value depreciation. that's a right!

You may have recently read an article about the staggering number of Americans on anti-depressants. Having no plans to join them, I took the precaution of heading out and buying a lot of cleaners and a new, ultra-fancy mop before reading the Humpty-Dumpty program release. (Cleaning vastly improves my mood.) Thus, I only laughed until I cried, rather than beginning in broken-hearted sobbing and ending into a descent upon my doctor demanding pills. So be warned if you are not in a good mood.

I will write about this if I ever regain my composure. I had not in my lifetime ever expected to laugh harder at Treasury programs (try FinancialStability.gov) than SNL skits, but hey, sometimes art presages reality.